A.

Zooming in on Net Operating Income

Each and every earnings season, there are large-cap companies missing their estimated
targets. On the day of the announcement a company's price can undergo inexplicable changes.
In most cases, there are few substantive changes in a company, from a strategic and
fundamental perspective. If small penny deviations in the EPS outcome can move the market
for better or worse, then what long-run profitability measure can an astute investor count on?
One possible answer lies in net operating income (NOI), a metric worth examining.

Defining Net Operating Income

Reports will often refer to NOI as NOPAT (net operating profit after taxes) or NOPLAT (net
operating profit less adjusted taxes). Regardless of which acronym is used, the underlying
concept is simple and expressed as follows:

NOI = operating income * (1-tax rate)

Earnings before interest and taxes (EBIT) is often used as a proxy for actual operating income,
so NOI is therefore also defined as follows:

NOI = EBIT * (1-tax rate)

[Note: For the sake of simplicity, derive the tax rate as 35%, a rate that can be assumed to be
applicable to most firms.]

Using NOI to Assess Companies

Although the firm's net income and subsequent earnings per share (EPS) constitute the much-
hyped bottom-line, NOI is often as relevant and more reliable than net income for the following
two reasons:

1. It Is More Difficult to Manipulate NOI

Generally accepted accounting principles (GAAP) of various governments make it clear which
income and expenses flow into operating income: hence, NOI should not be creative. In other
words, it is unwise for management to remove questionable expenses from the calculation of
operating income if these expenses are part of recurring operations. It is equally unjustifiable to
classify one-time income, such as special items and the sale of discontinued operations, as part
of the calculation of operating income and NOI. Why? Poor accounting can be treacherous from
both an investor-relations and a price perspective. This is especially true in the current
economic environment, where the slightest hint of potential fraud can send any stock price into
a tailspin.

Net income, on the other hand, can be altered considerably by below-the-line items such as
changes in accounting principles, special items and sales of discontinued operations. Every firm
is unique and should be analyzed with this tenet in mind. NOI, defined as an above-the-line item
and calculated without one-time changes, is not prone to the potential effects of the isolated
gains or losses that can significantly impact net income. Just as operating cash flow is often
seen as a cleaner measure of a firm's overall strength, the trend and direction of net operating
income can be viewed as an alternative to net income for the same reason: it's much harder to
manipulate.

2. NOI Is a Key Measure in Stock Valuation and Asset Management

Why is NOI used in forecasting? Why is a strong track record of sustainable NOI growth often
viewed as favorable? There is a second reason for calculating NOI. Without the influence of
these potential below-the-line distortions, NOI is largely the measure used by investment
management professionals to forecast not only the future trend in earnings but also the direction
of the firm's free cash flow. The two forms of free cash flow, which are free cash flow to firm
(FCFF) or free cash flow to equity (FCFE), dominate current valuation techniques of the large
institutional interests and mutual funds. Both of these measures can be calculated by adding
depreciation and subtracting both the firm's change in working capital and outflows related to
capital spending. If the multi-billion-dollar pension and mutual funds are placing enormous long-
term orders based on free-cash-flow-model techniques, then NOI, which is the root of both the
FCFF and FCFE forecasting, is essential to this process of stock valuation.

Conclusion

In short, NOI is an informative and constructive alternative to net income. The media has a long-
standing love affair with EPS. In many respects, this reporting makes sense, since earnings
surprises can impact short-term prices and it is quite easy for a non-technical commentator to
report whether or not a firm fell in line with EPS targets. This quarterly EPS focus is unlikely to
change. In many countries such as Germany, quarterly reporting is largely non-existent and
semi-annual reporting is the norm. It is nevertheless wise to look at how a firm's operating
income and NOI performed in comparison with last year's figure and whether or not there is a
positive or negative trend on the horizon.

Scrutinizing these two results a few lines above net income on the income statement may be
not only relevant in terms of past operational performance, but also more meaningful for a future
perspective. NOI and its reliability lie at the heart of widespread stock valuation techniques
based on derived and forecasted free cash flows.
B. The Bottom Line on Margins

Let's face it, the most important goal of a company is to make money and keep it, which
depends on liquidity and efficiency. Because these characteristics determine a company's ability
to pay investors a dividend, profitability is reflected in share price. As such, investors should
know how to analyze various facets of profitability, including how efficiently a company uses its
resources and how much income it generates from operations. Calculating a company's profit
margin is a great way to gain insight into these and other aspects of how well a company
generates and retains money.

Why Use Profit-Margin Ratios?

The bottom line is the first thing many investors look at to gauge a company's profitability. It's
awfully tempting to rely on net earnings alone to gauge profitability, but it doesn't always provide
a clear picture of the company, and using it as the sole measure of profitability can have big
repercussions.

Profit-margin ratios, on the other hand, can give investors deeper insight into management
efficiency. But instead of measuring how much managers earn from assets, equity or invested
capital, these ratios measure how much money a company squeezes from its total revenue or
total sales.

Margins, quite simply, are earnings expressed as a ratio - a percentage of sales. A percentage
allows investors to compare the profitability of different companies, while net earnings - an
absolute number - cannot.

Consider this example. In its final quarter of 2003, personal computer-maker Dell had an annual
net income of $749 million on sales of about $11.5 billion. Its major competitor, HP, earned
about $990 million for the year on sales of about $19.9 billion. Comparing HP's net earnings of
$990 million and Dell's $749 million shows that HP earned more than Dell, but it doesn't tell you
very much about profitability. If you look at the net profit margin, or the earnings generated from
each dollar of sales, you'll see that Dell produced 6.5 cents on each dollar of sales, while HP
returned less than 5 cents. That difference wasn't huge, but it was one of the reasons why the
market valued Dell more than HP.

There are three key profit-margin ratios: gross profit margins, operating profit margins and net
profit margins.

Gross Profit Margin

The gross profit margin - or gross margin for short - tells us the profit a company makes on its
cost of sales, or cost of goods sold. In other words, it indicates how efficiently management
uses labor and supplies in the production process.

Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales

Let's say a company has $1 million in sales and the cost of its labor and materials amounts to
$600,000. Its gross margin rate would be 40% ($1,000,000 - $600,000/$1,000,000).

Companies with high gross margins will have a lot of money left over to spend on other
business operations, such as research and development or marketing. So be on the lookout for
downward trends in the gross margin rate over time. This is a telltale sign of future problems
facing the bottom line. When labor and material costs increase rapidly, they are likely to lower
gross profit margins - unless, of course, the company can pass these costs onto customers in
the form of higher prices.

It's important to remember that gross profit margins can vary drastically from business to
business and from industry to industry. For instance, the airline industry has a gross margin of
about 5%, while the software industry has a gross margin of about 90%.

Operating Profit Margin

By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show
how successful a company's management has been in generating income from the operation of
the business:

Operating Profit Margin = EBIT/Sales

If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit margin would
be 20%.

This ratio is a rough measure of the operating leverage a company can achieve in the conduct
of the operational part of its business. It indicates how much EBIT is generated per dollar of
sales. High operating profits can mean the company has effective control of costs, or that sales
are increasing faster than operating costs.

Operating profit also gives investors an opportunity to do profit-margin comparisons between

companies that do not issue a separate disclosure of their cost of goods sold figures (which are
needed to do gross margin analysis). Operating profit measures how much cash the business
throws off, and some consider it a more reliable measure of profitability since it is harder to
manipulate with accounting tricks than net earnings.

Naturally, because the operating profit-margin accounts for not only costs of materials and
labor, but also administration and selling costs, it should be a much smaller figure than the
gross margin.

Net Profit Margin

Net profit margins are those generated from all phases of a business, including taxes. In other
words, this ratio compares net income with sales. It comes as close as possible to summing-up
in a single figure how effectively managers run the business:

Net Profit Margins = Net Profits after Taxes/Sales

If a company generates after-tax earnings of $100,000 on its $1 million of sales, then its net
margin amounts to 10%.

To be comparable from company to company and from year to year, net profits after tax must
be shown before minority interests have been deducted and equity income added. Not all
companies have these items, and investment income, wholly dependent upon the whims of
management, can change dramatically from year to year.

Again, just like gross and operating profit margins, net margins vary between industries. By
comparing a company's gross and net margins, we can get a good sense of its non-production
and non-direct costs like administration, finance and marketing costs.

You'll recall that the international airline industry - comprising companies such as British
Airways, United and Quantas - has a gross margin of just 5%. Its net margin is just a tad lower,
at about 4%. On the other hand, discount airline companies such as Southwest Airlines and
JetBlue generate average gross margins of about 29%. Their net margin is about 11%. These
differences provide some insight into these industries' distinct cost structures: compared to its
bigger, international cousins, the discount airline industry spends proportionately more on things
like finance, administration and marketing, and proportionately less on items such as fuel and
flight crew salaries.

Then there is the software business. It has an exceedingly high gross margin of 90%, but a net
profit margin of 27%. This shows that its marketing and administration costs are very high, while
its cost of sales and operating costs are relatively low.

When a company has a high profit margin, it usually means that it also has one or more
advantages over its competition. Companies with high net profit margins have a bigger cushion
to protect themselves during the hard times. Companies with low profit margins can get wiped
out in a downturn. And companies with profit margins reflecting a competitive advantage are
able to improve their market share during the hard times - leaving them even better positioned
when things improve again.

Conclusion

Margin analysis is a great way to understand the profitability of companies. It tells us how
effectively management can wring profits from sales, and how much room a company has to
withstand a downturn, fend off competition and make mistakes. But, like all ratios, margin ratios
never offer perfect information. They are only as good as the timeliness and accuracy of the
financial data that gets fed into them, and analyzing them also depends on a consideration of
the company's industry and its position in the business cycle.

Remember, margin ratios highlight companies that are worth further examination. Knowing that
a company has a gross margin of 25% or a net profit margin of 5% tells us very little without
further information. As with any ratio used on its own, margins tell us a lot, but not the whole
story, about a company's prospects.
C. Analyzing Operating Margins

Analyzing a company's operating results is often the most important aspect of equity analysis.
How well a company generates cash flows from operations dictates how well it can satisfy the
claims of creditors and create value for common shareholders. In order to assess this value
creation, investors do well by analyzing a company's operating income, operating cash flow and
operating margins. In this article, we will introduce the components and analysis of operating
income. (For background reading, see Zooming In On Net Operating Income.)

Why Are Operating Margins Important?

Operating income is revenue less operating expenses for a given period of time such as a
quarter or year. Operating margin is a percentage figure usually given as operating income for
some period of time divided by revenue for the same time period. Operating margin is the
percentage of revenue that a company generates that can be used to pay the company's
investors (both equity investors and debt investors) and the tax man. It is a key measure to
analyze a stock's value. Other things being equal, the higher the operating margin, the better.
Using a percentage figure is also very useful for comparing companies against or analyzing the
operating results of one company over various revenue scenarios.

Revenue can be derived in a number of ways depending on the type of business. Similarly,
operating expenses come from a variety of sources. Depending on the source, operating
expenses "behave" in a variety of ways.

Analysts often characterize expenses as either "fixed" or "variable" in nature. A fixed cost is a
cost that remains relatively steady as business activity and revenue change. A rent expense is
an example. If a company leases or rents a property, it usually pays a set amount each month
or quarter. This amount does not change regardless of whether business is good or bad at the
time. By contrast, a variable cost is one that changes as business activity changes. An example
is the cost of buying raw materials for a manufacturing operation. Manufacturing companies
must buy more raw materials when business speeds up; therefore, the cost of buying raw
materials increases as revenue increases.

Analyzing a company's mix of fixed and variable costs is often important in analyzing operating
margins and cash flows. When revenue increases, the operating margins of companies that are
fixed-cost intensive have the potential to increase at a faster rate than less fixed-cost intensive
companies (the reverse is also true). Because equity analysis involves projecting future
operating results, understanding the intensity of fixed costs is vital. Analysts must understand
how operating margins will change in the future given certain revenue growth assumptions.

Factoring in the Cost of Goods

A special and important form of expense is cost of goods sold (COGS). For companies selling
products that they manufacture, add value to or simply distribute, the cost of products sold is
accounted for using inventory calculations.
The basic formula for COGS is:

COGS = BI + P - EI

Where:

BI is beginning inventory

P is inventory purchases for the period

EI is ending inventory

COGS strives to measure the cost of inventory sold in a period; the actual amount incurred to
buy inventory might be significantly higher or lower. By netting out beginning and ending
inventory, companies try to measure the cost of the actual volume of product sold during the
period. Also note that a significant amount of overhead costs - like the power bill for a
manufacturing plant - is often embodied in inventory amounts and therefore in COGS itself. (For
more, see Inventory Valuation For Investors: FIFO And LIFO.)

Revenue less COGS is known as gross profit and it is a key element of operating income. Gross
profit measures the amount of profit generated before general overhead costs that are not
inventoriable, like selling, general and administrative (SG&A) costs. SG&A costs might include
such items as administrative staff salaries or costs to maintain a stock market listing. Gross
profit divided by revenue is a percentage value known as gross margin. Analyzing gross margin
is paramount in equity analysis projects because COGS is often the most significant expense
element for a company. Analysts often look at gross margin when comparing companies or
assessing the performance of a single company in a historical context.

Other Considerations

Investors should also understand the difference between cash expenses and non-cash
expenses when analyzing operating results. A non-cash expense is an operating expense on
the income statement that does not require cash outlay. An example is depreciation expense.
According to generally accepted accounting principles (GAAP), when a business buys a long-
term asset (such as heavy equipment), the amount spent to buy that asset is not expensed in
the same way as rent expense or raw materials cost might be. Instead, the cost is spread out
over the useful life of the equipment and, therefore, a small amount of the overall cost is
allocated to the income statement over a number of years in the form of depreciation expense,
even though no further cash outlay has occurred. Note that non-cash expenses are often
allocated to other expense lines in the income statement. A good way to grasp the effect of non-
cash expenses is to look carefully at the operating section of the statement of cash flows.

It is largely because of non-cash expenses that operating income differs from operating cash
flow. Investors are wise to consider the proportion of operating income that is attributable to
non-cash expenses. Analysts often calculate earnings before interest, taxes, depreciation and
amortization (EBITDA) to measure cash-based operating income. Because it excludes non-cash
expenses, EBITDA may better measure the amount of cash flow generated from operations that
is available for investors than operating income. After all, dividends must be paid from cash, not
income. Similar to gross margin and operating margin, analysts use EBITDA to calculate
EBITDA margin and they use this figure to do company comparisons and historical company
analyses. (For more, see The Bottom Line On Margins.)

Conclusion

In order to properly assess most equities, investors must grasp the issuer's ability to generate
cash flow from operations. It is therefore vital to understand the concepts of operating income
and EBITDA. As with most aspects of financial analysis, numerical comparisons can tell more
about a company than the actual financial parameters. By calculating margins, investors can
better measure a company's ability to generate operating income in competitive and historical
contexts.